A Primer on Marginal Tax Rates

Today, I have one video on another important principle of taxation. To set the stage for this discussion, here are two simple definitions

The “average tax rate” is the share of your income taken by government. If you earn $50,000 and your total tax bill is $10,000, then your average tax rate is 20 percent.

The “marginal tax rate” is the amount of money the government takes if you earn more income. In other words, the additional amount government would take if your income rose from $50,000 to $51,000.

These definitions are important because we want to contemplate why and how a tax cut helps an economy.

But let’s start by explaining that a tax cut doesn’t boost growth because people have more money to spend.

I want people to keep more of their earnings, to be sure, but that Keynesian-style explanation overlooks the fact that the additional “spending power” for taxpayers is offset when the government borrows more money to finance the tax cut.

Instead, when thinking about taxes and prosperity, here are the three things you need to know.

All this is completely correct, but there’s one additional point that needs to be stressed.

4. The tax rate that matters is the marginal tax rate, not the average tax rate.

I discussed the importance of marginal tax rates in 2016, pointing out that Cam Newton of the Carolina Panthers was going to lose the Super Bowl (from a financial perspective) because the additional tax he was going to pay was going to exceed the additional income he would earn. In other words, his marginal tax rate was more than 100 percent.

But I also included an example that’s more relevant to the rest of us, looking at our aforementioned hypothetical taxpayer with a 20 percent average tax rate on annual earnings of $50,000. I asked about incentives for this taxpayer to earn more money if the marginal tax rate on additional income was 0 percent, 20 percent, or 100 percent.

Needless to say, as shown in this expanded illustration, the incentive to earn $51,000 will be nonexistent if all of the additional $1,000 goes to government.

That’s why “supply-side economics” is focused on marginal tax rates. If we want more productive behavior, we want the lowest-possible marginal tax rates so people have the greatest-possible incentive to generate more prosperity.

Here’s a very short video primer on this issue.

One very important implication of this insight is that not all tax cuts (or tax increases) are created equal. For instance, as I explained in a three-part series (here, here, and here), there will be very little change in incentives for productive activity if the government gives you a tax credit because you have kids.

P.S. I’m not saying tax preferences for kids are wrong. But I am saying they’re not pro-growth.

P.P.S. I mentioned above that Cam Newton – based on his personal finances – lost the Super Bowl even before the opening kickoff. Well, there’s scholarly evidence that teams in high-tax states actually win fewer games.

P.P.P.S. Today’s analysis focuses on the individual income tax, but this analysis also applies to corporate taxation. A company with clever lawyers and accountants may have the ability to lower its average tax rate, but the marginal tax rate is what drives the incentive to earn more income. Which is why reducing the federal corporate rate from 35 percent to 21 percent was the best part of last year’s tax bill.

I hate to sound like a liberal, but many individuals love their job or their company and will continue to work full steam because they love it.

I agree with you though that they do make it hard, at 72 I’m getting tired of the BS. I also would eventually like to sell the business, and people are more hesitant to take on a business when taxes can be radically changed, and the BS will affect the value of the sale.

We need a radical change to the tax code, and then leave it there rather than tweak it every year. (States too!)

Note that typically the highest margin tax rates are assessed on the most competent people, i.e. those who have the most capacity to make a difference.

Add to that the effect of the marginal utility of money which decreases with income, eg. one already has less incentive to bump their income from $500k to $600k than someone contemplating bumping their income from $100k to $200k even before any taxation further decreases incentives, and you see the truly pernicious effect of exploding marginal tax rates. In other words, it is already difficult to keep successful people employed because of the decreasing marginal utility of money with rising income. Add to that progressive taxation and you have a real dampener on incentives to more prosperity.

But aren’t there a lot of capable rich people who keep working? Sure there are. But for each one that we see there are ten very competent people who quit earlier, at more mediocre wealth levels, who are anonymously and inconspicuously fishing at the lake, traveling the world, doing yoga and playing golf etc. We do not see these people in the news but they are people who would have created more jobs, higher paying jobs, more products, cheaper products, more competent products, more prosperity. For each conspicuously entrepreneur there are ten who quit earlier, much earlier, before they got pancreatic cancer like Steve Jobs. And so this is why the annual growth rate trendline in developed voter-lemming democracies hovers around a pathetic two percent (and even lower in welfare states) while the world average is slowly submerging said nations by growing twice as fast at around four percent.

But it’s rather hopeless. To the typical short sighted voter-lemming, who does not understand elementary growth exponents, a redistribution dollar today is worth five perpetually compounding growth dollars in the future. Hence the developed democracies will continue their secular decline down the worldwide prosperity rankings, and will be reduced to being middle income nations by mid century, when a much faster rising world average finally reaches their pathetically growing per capita income levels. Of course, the pain will start much before this critical parity milestone is reached. Hence the grumpy mood in the western world which (and this is the tragedy) reflexively draws voters to even more coercive collectivism as the dominant politics orient towards recruiting everyone to the cause of national salvation. The vicious cycle closes.

Hence, very few voter-lemming nations will escape decline. Hence, at the personal level, STAY MOBILE! And especially teach your children how to be so.

Lowering employee taxes assumes that the individual will spend more wisely than government. Given that +60% of government spending is on the safety-net, government spending will probably go into consumption rather than investment (growth). In addition much of government spending goes into overhead (non-growth).

So the general assumption is valid, even though government may spend the same amount one way or the other.

Taxes going into ultimate product cost are primarily employee and corporate. You cannot “replace” employee taxes with a consumption tax. Salaries do not go down, when you lower the employee’s taxes, he still gets the same salary.

Therefore, if you lower taxes on salaries and add a consumption tax, prices must go up.

When rates are high enough that a decrease in rates yields an increase in revenue, they are objectively punitive rates; I’m pretty sure 50% is well on the falling side of the Laffer curve of rate vs. revenue.

You also need to cap the combined income tax rates per level of government. Especially, the feds need to be prohibited from doing transfers of revenue to states in order to encourage tax and service competition.

Even if you solve that, you run into the fact that income taxes are stealth value-added taxes that get factored into the cost of everything you purchase, so we really need to replace them with retail-only consumption taxes.

Completely agree that what matters most is the marginal tax rate rather than the average (or effective) tax rate. Too many people do not understand this point. Yes, it’s a little better if taxpayers can spend more of their own money, as compared to having govt spend it. But it’s a LOT better for prosperity to maximize the after-tax incentive (low marginal rates) to work, save, and invest productively. i.e., more about incentives and behavior than who is spending the money.

As for top personal tax rates, I think neither average nor marginal tax rates (of all types) should ever exceed 50%. Over 50% means you’re working more for govt than for yourself or your family. Why should anyone have to do that?!